Money/Bond market outlook for FY13

Money/Bond market outlook for FY13

FY12 was traders delight with high confidence level on predictability of the trend. RBI continued with its hawkish stance on monetary policy till December and signalled shift into pause mode taking cues from establishment of downtrend in headline inflation and pressure on growth momentum. During this time, RBI maintained deficit system liquidity to keep money market rate curve at elevated levels. RBI did not have the option as the economy faced strong headwinds from external sector. The economic concerns were many driven by slippage in growth momentum; overshoot in fiscal deficit and inability to roll-out next generation economic reforms. The domestic and foreign investor confidence was low and consumer sentiment weak to put pressure on core growth and consumption. The system was operating on sub-optimal capacity, thereby not meeting budgeted revenues. FY12 was the year which the Government and RBI will like to take out from memory and look forward to much improved performance in FY13; it cannot go much worse from here. It is heartening to note that the market has traded to the script of MARKET PULSE in FY12. The recommendation was to stay invested in 10Y at yield 8.75-9.0% and to churn the book by exit at 8.25-8.10% by shift into 1Y bond at 8.50-8.65%. 10Y bond yield traded end-to-end of 8.15-8.85% with overshoot either-way could not sustain. 5Y OIS rate too traded end-to-end of 6.65-7.65% range to trigger pay recommendation below 6.75% for move into 7.65%. Over all, despite economic and monetary gloom, there were plenty of opportunities for investors and traders to make attractive returns on the principal; hence the FY12 investment strategy of 100% allotment in Fixed Income assets for capital preservation with attractive yield.

There is now tremendous pressure on the money market with low money supply and high demand from the Government. The shift in corporate credit demand from foreign currency to rupee since July 2011 Euro zone crisis has added to pressure. The leverage ratio has also gone up on significant cut in internal cash accruals of borrowers. RBI’s monetary stance of maintaining deficit system liquidity at elevated cost has extended beyond tolerance level. The way forward is highly dependent on the timing of shift of deficit system liquidity to surplus mode, thereby pushing the operative policy rate from Repo rate to Reverse Repo rate; resultant 1% downward shift in overnight rate curve will give flexibility to RBI to delay rate cut actions. Having said this, it would be very difficult to execute this plan with system shortfall at over Rs.1 Trillion; would need one-shot CRR cut by over 1.5% and continuation of OMO bond purchases to bridge demand-supply gap. Thereafter, RBI can choose to get into rate cut mode on getting comfort from factors that remain as major risk to inflation such as rupee exchange rate; crude oil price; core inflation and trend on Governments’ revenue/expenses as per projections. Needless to say, investors’ confidence (and appetite) will be high only when system is in surplus liquidity mode irrespective of the yield at that point of time; fear of lending to RBI (at Reverse Repo counter) will create demand. It is also important to give priority to growth issues to provide stability across asset markets and to cut bearish linkages.

The outlook for FY13 is mixed and is expected to turn bullish (and supportive) only on significant improvement in structural market dynamics. We believe that RBI will take quick remedial measures to address structural imbalances to provide better confidence on the way forward. Given this expectation, shorter end of the rate curve will benefit the most while bringing stability in the medium to longer end; establishment of downtrend in the shorter end and removal of bearish set up in the medium/longer end is considered positive at this stage. The expectation in FY13 is for delivery of 75-125 bps CRR cut; 50 bps rate cut and Rs.1.5-2.0 Trillion of OMO bond purchases. The timing of actions have to be front-ended (most in Q1 and rest in Q2) to get the best results. The expectation therefore will be for delivery of 50 bps rate cut in Q1; next round of CRR cuts in Q2 and OMO operations in Q3/Q4. This would mean shift of LAF corridor into 7.0-8.0% in Q1 (and for rest of FY13) and allow pass-through of operative policy rate from higher end to lower end in Q2 (and for rest of FY13).

What is the impact on the market? The average overnight MIBOR for FY13 will be around 7.75% with downtrend in 3-12M term money rates into 8.5-9.5% by end of Q2. This sets up objectives for 1Y bond yield at 8% and 1Y OIS rate at 7.75%. There will be significant release of pressure on the medium to longer end bonds. 10Y bond yield will look attractive at 8.75-8.85%; not ruling out extended weakness into 9.0% if unpleasant surprises come up. Strategic investors can look to buy this weakness into 8.75-8.85% with appetite to add on extended weakness into 8.95-9.0%. There will be trend reversal from there into 8.50-8.35% on improvement in factors that are considered as major risks to inflation and deterioration in factors that are considered as major risk to growth. The range to watch in FY13 for 10Y bond is at 8.50-8.85%; allowing unsustainable extension into 8.35-9.0%. This sets up FY13 range for 5Y OIS at 7.50-7.65% not ruling extended move within 7.35-7.80%. It would be good to initiate pay in 5Y OIS at 7.50-7.35% and build up received book at 7.65-7.80%. The major risk factor to this expectation is on pressure on inflation from rally in BRENT Crude over $135 and weak rupee over 53; considered as low probability at this stage. On the other side, rally in rupee into 47 and reversal in BRENT Crude below $115 would be very bullish for extended gains below the lower end of set ranges. It is not the time for RBI and the Government to take conflicting stance in their respective positions (Government’s priority for growth and RBI’s priority on inflation) and it would need balancing act to prevent slippage from bad to worse. This is the basic assumption that has driven the above expectations; believe, there is no second option at this point of time. It is not the time for investors to get panic on fear of the worst; it is the time to stay invested for good returns during the course of FY13.

Moses Harding